LECTURE 15: MARKET STRUCTURES (CONTINUED)
15.1 OLIGOPOLY
Similar to monopoly in the sense that there are a small number of firms (about 2-20) in the
market and, as such, barriers to entry exist. It is similar to perfect competition in the sense
that firms compete with each other, often feverishly, which may result in prices very similar
to those that would obtain under perfect competition. It is similar to monopolistic
competition since there is a possibility of having differentiated products.
15.2 DIFFERENCE OF OLIGOPOLY WITH OTHER MARKET STRUCTURES
An oligopoly is a market form in which a market or industry is dominated by a small number
of sellers (oligopolists). The word is derived from the Greek for few sellers.
• Because there are few participants in this type of market, each oligopolist is aware of
the actions of the others. The decisions of one firm influence, and are influenced by the
decisions of other firms. Strategic planning by oligopolists always involves taking into
account the likely responses of the other market participants. This causes oligopolistic
markets and industries to be at the highest risk for collusion.
•
It is not possible to identify any single equilibrium in oligopoly. Theory of firm is not
clearly discussed & established as the theory of firm in the other three market
structures. Reason for that is the firms are interdependent.
15.3 COLLUSION
Collusion occurs when two or more firms decide to cooperate with each other in the setting
of prices and/or quantities. Firms collude in order to maximize the profits of the industry as a
whole by behaving like a single firm. In doing so, they try to increase their individual profits.
In the study of economics and market competition, collusion takes place within an industry
when rival companies cooperate for their mutual benefit. Collusion most often takes place
within the market form of oligopoly, where the decision of a few firms to collude can
significantly impact the market as a whole. Cartels are a special case of explicit collusion.
Collusion which is not overt, on the other hand, is known as tacit collusion.
At one time, all the firms sit together and combine their decisions in order to maximize
profits & behave like monopoly. But at the same time, since all these firms have separate
identity, they have the desire also to maximize their own individual profits as well. They
might behave like single firm but they can also try to maximize their individual profits. This
opposing situation creates tension. This tension can lead to collusion to break down.
15.4 TWO POSSIBLE SCENARIOS OF OLIGOPOLY
This tension between collusion & competition give rise to two possible scenarios that the
oligopolist firms can have:
1. Collusive oligopoly
2. Non-collusive oligopoly
15.4.1 COLLUSIVE OLIGOPOLY (CARTEL)
A collusive oligopoly (or cartel) can be formed by deciding upon market shares, advertising
expenses, prices to be charged (identical or different) or production quotas, such as OPEC,
are collusive oligopolies. A firm can collude in many different ways. For example, they can
collude on the market share in total profits. Collusion can also be done in terms of how much
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advertising expenditures each firm would have to put. They can also set the prices and
quotas. If firms are not of equal size, then quotas can be allocated according to the MC of
each firm. Cost of the cartel firm is minimized if the MC of each of the firm is equal. But the
problem with this quota system is that firms which have higher MC will get lower quotas and
the firms which have lower MC will get higher quotas.
Cartel
A cartel is a formal (explicit) agreement among firms. Cartels usually occur in an
oligopolistic industry, where there are a small number of sellers and usually involve
homogeneous products.
A cartel is most likely to survive when the number of firms is small, there is openness among
firms regarding their production processes; the product is homogeneous; there is a large firm
which acts as price leader; industry is stable; government’s strictness in implementing antitrust (or anti-collusion) laws. Govt regulations are helpless against internationally operational
cartels or when collusion is tacit (or hidden) not explicit.
15.4.2 NON- COLLUSIVE OLIGOPOLY
If different firms in the oligopolistic structures do not cooperate with each other is known as
non collusive oligopoly. In this case, collusion breaks down because the incentive to cheat is
very high. This can arise, for instance, in a situation where there is a lure of very high profits
so that individual firms cheat on their quota and try to increase output and profits. But this
causes everyone else to do the same and therefore supply soars and prices tumble producing
in effect a non-collusive oligopoly.
The incentive to collude becomes strong for members of a non -collusive oligopoly when
firms are not making good profits. Thus oligopolies usually oscillate between collusive and
non-collusive equilibria.
15.5 COLLUSION & GAME THEORY
The Prisoner’s Dilemma Situation
Consider about the two prisoners who have committed a crime together. Both have been
arrested by the police and kept in separate cells. They have been interrogated separately
about their crime. The dilemma is this if both confess to a crime they each have to face the
punishment of 5 years in jail.
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If they do not confess then police has no evidence to keep them and police will let them go
free. Their punishment will be very minor or might be zero in this case.
If one testifies for the prosecution against the other and the other remains silent, the betrayer
goes free and the silent accomplice receives the full 10-year sentence. If both remain silent,
both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the
other, each receives a five-year sentence. Each prisoner must make the choice of whether to
betray the other or to remain silent. However, neither prisoner knows for sure what choice
the other prisoner will make. So this dilemma poses the question: How should the prisoners
act?
The dilemma arises when one assumes that both prisoners only care about minimizing their
own jail terms. Each prisoner has two and only two options: either to co-operate with his
accomplice and stay quiet, or to defect from their implied pact and betray his accomplice in
return for a lighter sentence. The outcome of each choice depends on the choice of the
accomplice, but each prisoner must choose without knowing what his accomplice has chosen.
In deciding what to do in strategic situations, it is normally important to predict what others
will do. This is not the case here. If one prisoner knew the other prisoner would stay silent,
his best move is to betray as he then walk free instead of receiving the minor sentence. If he
knew the other prisoner would betray, his best move is still to betray, as he receive a lesser
sentence than by silence. Betraying is a dominant strategy. The other prisoner reasons
similarly, and therefore also chooses to betray. Yet by both defecting they get a lower payoff
than they would get by staying silent. So rational, self-interested play results in each prisoner
being worse off than if they had stayed silent.
A prisoner’s dilemma situation for oligopolistic firms arises when 2 or more firms by
attempting independently to choose the best strategy anticipation of whatever the others are
likely to do, all end up in a worse position than if they had cooperated in the first place.
Payoff of a matrix for firm
X& Y (profit in Rs: at
different prices)
There are four points to be noted in this table:
• If both X & Y firms charge same price of Rs.2 then they get same profit of Rs.10
million as shown by option A.
•
If both firm independently thought about reducing the price to Rs.1.8 then they have to
take into account the decision of other firm. They have to think about what their rival
will do? Their rival can do two things either to lower the price or kept the same price
level. Now if X kept his price at Rs.2 the worst thing for X would be that its rival Y
cuts its price to Rs.1.8. X’s profit will now fall to Rs.5 million and Y’s profit will
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•
•
increase to Rs.12 million due to lower price. This is shown in option C.
If however, X cuts its price to Rs.1.8 the worst outcome still would be Y to cut its
price too to Rs.1.8. but this time X’s profit will only fall to Rs.8 million and Y’s profit
will also fall to Rs.8 million. This is shown in option D.
However if X think optimistically and cuts its price to Rs.1.8 with his optimistic
assumption that Y will leave with its price at Rs.2. if X is right in his assumption then
he will earn the maximum profit of Rs.12 million and Y will earn Rs.5 million. This
option is shown in option B.
Maximin strategy
Maximin strategy is a cautious (pessimistic) approach in which firms try to maximize the
worst payoff they can make. It is the policy of adopting the safer side. It means the firm is
trying to maximize the minimum profit that it will make.
Maximax strategy
A Maximax strategy involves choosing the strategy which maximizes the maximum payoff
(optimistic). This policy arises from the optimistic approach that your rival will react most
favorable to you. It means firm is going for the maximum possible profit.
Dominant strategy game:
Both these strategies leads towards the same strategy that is cutting down of price to Rs.1.8.
this type of game is called the dominant strategy game. Given that both X & Y are tempted to
lower price, they both end up tempting the lower profit i-e Rs.8 million each. If they collude
and charge the same price, they will get profit of Rs.10 million each. Thus collusion rather
than price war would be beneficial for both.
15.6 PRICE STABILITY IN NON-COLLUSIVE OLIGOPOLIES: KINKED DEMAND
CURVE
A kinked demand curve explains the “stickiness” of the prices in oligopolistic markets. The
theory of kinked demand curve rests on the two assumptions that if one firm raises prices, no
one else will raise their prices and so the firm will face declining revenues (elastic demand).
However if one firm lowered its price, everyone else would lower their prices as well and
everyone’s revenues, including the first firm’s revenues would fall (inelastic demand).
A demand curve with two distinct segments which have different elasticities that joins to
form a corner or kink. The primary use of the kinked-demand curve is to explain price
rigidity in oligopoly. The two segments are:
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(1) A relatively more elastic segment for price increases
(2) A relatively less elastic segment for price decreases
The relative elasticities of these two segments are based on the interdependent decisionmaking of oligopolistic firms.
Non Price Competition:
Non price competition means competition amongst the firms based on factors other than
price, e.g. advertising expenditures.
Oligopoly & public interests:
In oligopoly, firms are able to earn super normal profits. This is also the feature of monopoly.
But this is not the feature of perfect competition & monopolistic competition. Firms can use
their profits in cost minimization techniques.
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